MITOCW | watch?v=HdHlfiOAJyE The following content is provided under a Creative Commons license. Your support will help MIT OpenCourseWare continue to offer high quality educational resources for free. To make a donation or to view additional materials from hundreds of MIT courses, visit MIT OpenCourseWare at ocw.mit.edu. ANDREW W. LO: So on behalf of the Sloan School I want to welcome all of you to 15.401 Finance Theory. This course is meant for first year MBA students. And so that's the focus, and I'm going to assume that that's the background that all of you will have. We may have a few other students in the class, but primarily it will be first year MBAs who are thinking about a career in finance, as well as those of you who aren't sure about a career in finance but are curious about it. Hopefully over the next 13 weeks we'll be able to satisfy that curiosity. I want to start by talking a little bit about what finance is, and how I got interested in it, because I think it's often helpful in order to motivate a subject to get a sense of how somebody else decided to choose this as a profession. To do that I have to go back a little bit, and give you some background about my own educational experiences. So let me start by mentioning that I've been at MIT for the past 20 years, and been in the finance group all that time. Before that I taught at the Wharton School for four years. And before that, I got my PhD in economics from Harvard University, and then graduated in 1980 from Yale also majoring in economics. And during that time I've learned an enormous amount both about finance and the real world, but one of the things that I keep coming back to is the fact that the finance field is almost unique in how it applies to practical management problems. And what I want to try to do over the next 13 weeks is to convince you of the fact that finance is in fact, the most important subject that you'll ever encounter. That in fact, finance is at the core of everything that you will ever do in business and in management. Now that's a tall order I recognize, and I suspect that some of you are quite skeptical about the role that finance might play in your own career objectives. And I know many of you have very different career objectives. And I'm not even trying to convince all of you to go into a career in finance, but I am trying to convince all of you that finance is really the lifeblood and the basic lingua franca of all of business. And that's one of the reasons why finance is such an important subject. Now before I begin, let me ask you a question. How many people have had no finance background whatsoever? Oh, that's great. I look forward to a challenge. But the other reason it's great is I have to tell you that it's a real privilege for me to be here in front of you to tell you about finance for the very first time. And it reminds me a little bit of my younger son who is an extraordinarily fussy eater, he's eight years old now. But ever since he was born he had some
allergies, and he just refused to eat most of everything. In fact, my wife often says that my younger son is a vegetarian except he doesn't eat vegetables. So he's an incredibly fussy eater, and somehow when he was one year old he saw my older son eating an ice cream cone, and figured that that's something he ought to try. How he figured that out, I don't know. But he tasted it for the very first time, and you could see his face change in about four seconds from disgust to curiosity to absolute, you know, enthrallment with the taste and feel of ice cream. He just loved it thereafter. That's one of his major food groups now. It's ice cream. And so I feel privileged to be able to share that experience here in the sense that once you get a taste of finance, I think you're going to be incredibly excited and enthralled by the subject. Because it's one of the few subjects, in fact, that's the only subject that I've encountered that is both rigorous, it's extraordinarily challenging from a research and intellectual perspective, and at the end of the day it's extremely practical. In fact, I would say it's indispensable for financial management. So I'm going to try to convince you of that over the next 13 weeks, and I'm going to do that by going over material that you will find indispensable. As many of you know, at the end of the course we have a ritual where we hand out teaching ratings. And among the finance faculty, among all the faculty, we're very concerned about good teaching. So these teaching ratings actually matter. And I've always thought that having a teaching rating survey at the end of the semester, is somewhat misguided. What I'd like to do, and what I've proposed hasn't been adopted yet, I propose to have teaching ratings submitted five years after a course is done. Now this may be a problem for some people who aren't up to speed in the classroom. But the reason I say this is, because it will only be after you get into your jobs, into your careers, before you realize how useful finance is. And five years from now, I suspect all of you will come back and say, gee, this is one of the most important courses you have ever taken. Not because of me, but because of the substance of what we're going to cover over the next 13 weeks. It's because of you and all of the work that you will put into this course. This will be the most challenging course you will ever love. So I-- stealing from the military-- I think that you'll really appreciate how the discipline of financial logic will help you to think smarter about all of your management decisions no matter what you decide to do with your careers. Now that's a very tall order. I've built up expectations.
So I'm going to have to deliver over the next 13 weeks, and we'll see whether or not we can do that. But let me start now by talking about what we're going to cover today. I want to start with a little bit of motivation, and then talk about the dramatis personae. These are the cast of characters that we're going to be focusing on over the next 13 weeks. And then I'm going to lay out the fundamental challenges of financial analysis. It turns out there are only two. There are only two challenges in financial analysis, and once you figure both of those out, you're done. So if by chance you can figure that out before the end of the class, you don't need to come back for the rest of the lectures. Then I'm going to turn to providing you with a framework for thinking about these financial challenges. To me it's very important to have a framework to start with, because I like to organize my thoughts into things that I know and things that I don't know. And of the things that I know, how did it relate to the stuff that I already knew, or thought I knew. So I want to give you a sense of that kind of framework to think about financial analysis upfront. You probably won't fully appreciate it at this point, but sometime over the next 13 weeks you will get it. And so I want to give that to you so that you can start thinking about it subconsciously, unconsciously, and then eventually you will understand how all the pieces fit together. I then want to talk about the importance of two aspects of financial analysis that make finance different from every other discipline you will ever encounter here at MIT and elsewhere. And that is time and risk. Without those two factors it turns out that finance is actually done. In other words, there's no real research challenges, no open questions left once you eliminate time and risk. Put in another way, the only reason that there exists a finance department, and finance faculty, and finance journals, and a finance industry, the only reason is because of time and risk. So I'm going to come back to that. Then I'm going to conclude by giving you the six basic principles of finance. These are principles that you will encounter in all of your finance courses for the rest of your stay at MIT and elsewhere. These are the ideas, the fundamental ideas, that have shaped financial markets and that are at the root cause of all of the financial market innovations, as well as all of the financial market crises that we've seen including what's been going on over the last several months in the subprime mortgage market. In fact, we're going to talk about the subprime mortgage problems after we cover fixed income
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